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Challenging A Call On An On Demand Performance Bond

25 November 2017

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Sato Kogyo was engaged to construct internal access roads involving earthworks as part of a preliminary works sub-contract for Salini relating to a power plant project in Cameron Highlands. The earthwork required an earthwork permit under Section 6(1) of the Land Conservation Act 1960. The problem was that although there was one such permit it was restricted to an area of 8.5 hectares and Sato Kogyo was required by Salini to carry out earth works beyond the area of the earthwork permit. A dispute arose between the parties essentially as to whether Sato Kogyo could carry on with the works without the permit, which party was responsible for procuring the permit and over Sato Kogyo’s notification of its intention to claim for an extension of time. Sato Kogyo was advised by its lawyer to stop earthwork immediately because to proceed without the permit was illegal. Alternatively Sato Kogyo was advised to obtain indemnities from Salini if it did continue with the earthwork in the absence of the permit. On 24 May 2011, having refused to further perform the Sub-Contract, Sato Kogyo issued a notice of withdrawal from the Sub-Contract to Salini.

Salini responded on 30 May 2011 determining the Sub-Contract.

Sato Kogyo took the matters in dispute to arbitration whereupon the parties agreed to have liability issues heard first followed by quantum issues thereafter, if necessary. They also agreed on the liability issues to be decided by the tribunal via ten questions.

Sato Kogyo’s sub-contract required that it execute a performance security in favour of Salini which it duly provided courtesy of Alliance Bank. The security was in the form of an unconditional demand guarantee. Salini through its solicitors sought an extension of the performance security that was about to expire due to the delays encountered to the project. Sato Kogyo refused saying there was no basis for doing so until the liability issues and arbitration award had been rendered by the tribunal and promptly went off to court seeking an injunction on a call being made on the performance guarantee. The parties resolved their differences over the performance guarantee by way of a compromise: Salini could make a call on the performance guarantee, but agreed not to receive the sum called until the award on liability was delivered.

The liability award was rendered on 27 June 2013 and included answers to the ten questions which the parties had agreed to have answered by the tribunal. The tribunal found that Salini were responsible contractually for applying for the revised earthwork permit beyond the original 8.5 hectares and that it represented to Sato Kogyo that it would do so. The revised earthwork permit wad dated 19 August 2011 and thus there was a gap of time between when the expiry of the validity of the 12 January 2011 permit and the issue of the permit dated 19 August 2011. Although the tribunal found that Sato Kogyo was permitted to argue that the Sub-Contract works were unlawful under the circumstances it was not entitled to issue the notice of withdrawal from the Sub-Contract on 24 May 2011. Salini’s was entitled to determine the Sub-Contract since Sato Kogyo’s refusal of further performance of the Sub-Contract amounted to a repudiation of the Sub-Contract which repudiation was accepted by Salini. The tribunal’s rationale for its decision was that Sato Kogyo ought to have suspended the work instead of terminating the Sub-Contract.

On 4 July 2013 Salini gave Sato Kogyo notice of its intention to receive the monies under the performance guarantee. Sato Kogyo went off to court again to try to prevent the call on the performance guarantee from being successful. The crux of Sato Kogyo’s argument was that under the circumstances suspension was not an option as Salini refused to instruct them to suspend in relation to the earthworks permit issue and that Salini had made it clear that they would find Sato Kogyo in breach if they had suspended. Consequently Sato Kogyo argued that their attempted termination was their only option and that since the Sub-Contract had been terminated by Salini there was no performance left to secure. Furthermore, they said that the performance guarantee was directly dependent on the Sub-Contract because of its terms which accordingly to Sato Kogyo required Salini to show Sato Kogyo was in breach of their obligations before payment could be made.

Sato Kogyo said that because it was prevented from performing its obligations under the Sub-Contract due entirely to the fault of Salini, it was unconscionable for the Defendant to now demand that monies be released to them under the performance guarantee. They went on to say that Salini knew early on about the earthwork permit issue but kept quiet and although they took the position with Sato Kogyo that no permit was required, nevertheless took steps to apply for the revised 19 August 2011 earthwork permit again without telling Sato Kogyo. This was all mala fides conduct argued Sato Kogyo and therefore it was unfair for Salini to be allowed to receive monies under the performance guarantee.

Salini on the other hand argued that the arbitral tribunal had found that Sato Kogyo was in breach of the Sub-Contract by refusing to proceed with the works and therefore a call on the performance guarantee was valid. The unconditional demand guarantee was independent of the Sub-Contract and any disagreement by Sato Kogyo with the arbitration award was really irrelevant to the question of whether Salini was entitled to payment under the performance guarantee. The only way of preventing a call was to prove fraud or unconscionability.

Since there was no suggestion of fraud, this left Sato Kogyo having to prove that Salini’s actions under the particular circumstances amounted to unconscionable behaviour. Sato Kogyo was unhappy that they were found in breach for refusing to continue with the works in the absence of an earthworks permit when procurement of the same was Salini’s responsibility. Although clearly not content with the arbitral award, Sato Kogyo was however not alleging that Salini’s behaviour in calling the performance guarantee in itself was unconscionable. Instead Sato Kogyo argued that meeting the demand would be unconscionable in circumstances where it considered the arbitral award to be wrong.

The court said that on the terms of the performance guarantee in question all that was required was a written demand accompanied by the original guarantee and a written statement stating that the Sub-Contractor was in breach of its obligations under the Sub-Contract. Salini had complied with these simple requirements. The bank’s irrevocable promise to pay must be honoured and no restraint should be allowed except in very limited circumstances (i.e. fraud or unconscionable behavior). Unconscionable conduct is one of fact the court said, which must be “of such a degree such as to prick the conscience of a reasonable and sensible man” as per the Federal Courts decision in Sumatec Engineering and Construction Sdn Bhd v Malaysian Refining Company Sdn Bhd [2012] 4 MLJ 1.

In Sumatec the Federal Court addressed the issue of unconscionability as a separate and distinct ground from that of fraud to restrain a beneficiary from making a call on a performance bond. In that case the conduct of the respondent was scrutinized to identify unconscionable behavior. For example, an agreement in principle to reduce the value of the performance bond due to a corresponding significant reduction in the contract sum was apparently ignored when a call was made. Another factor considered was the timing of the call, one year after a provisional acceptance certificate had been issued. These factors were ultimately found not to amount to unconscionable behaviour. So whereas the Federal Court in Sumatec identified the possibility of a separate and distinct ground to that of fraud to restrain a call on a performance security, there must be manifest or strong evidence provided as a matter of fact to establish unconscionable behaviour.

The court determined that Sato Kogyo had not met the unconscionability test prescribed in Sumatec because although Sato Kogyo clearly disagreed with the arbitral award, the arguments against the award could not be properly taken in the proceedings to prevent a call on the performance guarantee. Although the demand evidently flowed from the arbitral award, this cannot amount to unconscionability otherwise the flood gates would be wide open due to the ease with which such a claim could be made. There must be some relevant material fact to show the unconscionability of the demand.

The court also pointed out that the award remained good unless and until it iwa successfully challenged and set aside. Until then, Salini had every right to call on the performance security. The court concluded that these circumstances cannot and do not come close to amounting to unconscionability. Sato Kogyo’s attempt to restrain a call on the performance guarantee by Salini was therefore unsuccessful.

Rodney is the Chief Executive of the Charlton Martin Group, having previously been employed as Group Regional Director and Senior Vice President of two major contracts consultancy groups in the Asia Pacific Region. Of his 33 years of experience, 23 have been at senior level in this region. Additionally, Rodney has worked for many clients in Europe, Africa, the Middle East and India. Rodney holds dual qualifications in quantity surveying and law and as a chartered quantity surveyor is a specialist in construction contract consultancy providing professional and technical advice to clients relating to contract documentation, contractual claims, dispute avoidance and resolution. He is an accredited mediator, panel arbitrator and panel adjudicator with the Asian International Arbitration Centre and is an experienced speaker within the region. He is a Fellow of the Chartered Institute of Arbitrators as well as both the Malaysian and Singapore Institute of Arbitrators. Rodney has been appointed as Expert Witness on matters relating to quantum and delay and has acted as lay advocate in arbitration proceedings. Rodney has also been appointed as an arbitrator, mediator, adjudicator and dispute adjudication board member in Malaysia. He has lived and worked in Kuala Lumpur since 1997.